Tag: Imbalances

I had the good fortune to attend the INET 2014 conference this past weekend, to hear speak a variety of luminaries whose work I have been reading for years, and to meet bloggers with whom I have debated arcane points that none of my non-internet-based friends care about. I had a conversation there that I think sheds light on the causes of the Great Depression.

The gold standard is conventionally portrayed as synonymous with financial stability. … A central message of this book is that precisely the opposite was true. Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.

More recently Eichengreen and Peter Temin conclude that a gold standard ideology played an important role in worsening the Depression. They quote in their conclusion an author who wrote in 1932:

What is astonishing is the extraordinary hold which what is called the gold mentality has obtained, especially among the high authorities of the world’s Central Banks. The gold standard has become a religion …

Certainly in retrospect it seems likely, that had Britain gone off gold in 1924 — before the accrual of seven years of credit imbalances built on a disequilibrium exchange rate — the world economy’s adjustment to that event would have been less traumatic than the events that took place after 1931. The question then is why there was such a strong commitment on the part of the world’s central bankers to supporting Britain in the maintenance of the gold standard.

I had a conversation at INET in which the following question was discussed: Why are the central bankers committed to coordinating with the ECB on protecting the Eurozone when there is a significant possibility that the politicians will fail to make the necessary adjustments, that the Eurozone will break apart, and that in retrospect their actions will appear ill-advised? The conclusion was this: from the point of view of the central bankers the immediate costs of failing to support the Eurozone are so high, that the central bankers have no choice but to have faith that the politicians will play the role they need to play.

If the same dynamic was at play historically, perhaps the golden fetters that chained central bankers in the 1920s and 30s were not ideological at all. But simply the fact that given a choice between causing an immediate crisis and leaving open the possibility, even if small, that the crisis can be avoided by political action, they could not bring themselves to take the pessimistic-realistic view. Maybe the central bankers in the 1920s and 30s felt that they had no choice but to place their faith in politicians, who were not worthy of that faith.

Marshall Auerback (h/t Naked Capitalism) doesn’t quite say, but strongly implies, that the Clinton era budget surplus caused the rise in private sector indebtedness that has caused so many problems.

I think there’s a sense in which this is true, but that the underlying problem is excessively high growth targets (i.e. expectations of economic performance). The politicians wanted declining budget deficits and strong growth in an economy where the banking system was already undercapitalized. In order to square the circle, the regulators changed the rules so that more debt could be issued with lower levels of capital — that is, the regulators approved the growth of the shadow banking system and the use of “hybrid capital” (=debt masquerading as equity) — because there was no other way to square the circle.

The interconnectedness of the international financial system is built on limitations. In the 1920s these were the limitations set by the gold standard. Nowadays these are the limitations created by the legal status of derivatives. It is these limitations, which are perceived to protect the value of cross-border contracts, that make it possible for closely intertwined financial markets to develop.

Interconnectedness: Golden Fetters

In the 1920s and early 30s cross border transactions depended on the operation of the gold standard. Many cross-border contracts were denominated in sterling, though the dollar was growing in importance. After the Dawes plan and the stabilization of the German currency, the flow of private sector funds from the US to Germany – denominated in marks – grew dramatically. Thus, one of the reasons the gold standard was viewed as essential to the stability of the international financial system, was that the decision to go off gold by Britain, the US or Germany was sure to generate an international insolvency crisis.

Because of the structure of international trade, for the key countries whose currencies were used in foreign trade contracts the act of going off gold functioned as a means of transferring equity from the balance sheets of foreign banks and firms to the balance sheets of domestic banks and firms. In short, one thing was certain: the day Britain (or the US or Germany after Dawes) went off gold, that action would trigger an international insolvency crisis.

Needless to say, nobody could tell what would be the consequences of an international insolvency crisis and everybody who understood the consequences of leaving the gold standard was fearful that not only would formerly prosperous economies suffer immensely, but that the political consequences could also be disastrous. This fear of a coming apocalypse drove central bankers – for the most part with the support of their governments – to do everything they could to avoid going off gold and triggering the subsequent insolvency crisis.

The problem with the effort to defend the gold standard was that in order to be successful the defense required universal cooperation. And in the post World War I environment, there were many contentious issues that precluded genuine cooperation: not only were differences over war debts and reparations almost impossible to resolve, but countries such as France were very jealous of the key role sterling had played in the world economy over the previous decades and sought to bolster their own position in the world of international finance – even as Britain was determined not to give up its leading role. Thus, the measure of cooperation that was necessary to preserve the gold standard was unachievable in practice.

For this reason, the attempt to preserve the gold standard was an optimist’s boondoggle. In retrospect, we know that going off gold was inevitable.

If the central bankers of the mid-twenties had known that their efforts at developing a cooperative solution to the problems they faced were doomed to failure, they might not have postponed the insolvency crisis, but instead let it break earlier. Just imagine how different European history might be, had Britain chosen in 1925 – after the Dawes plan had opened a window for European recovery – to devalue before returning to gold. If the financial world had not been struggling through the latter half of the 20s to carry on despite seriously undervalued and overvalued currencies – while at the same time building up cross-border obligations which would collapse in value in the 30s, it is possible that (i) the solvency crisis would have been smaller and (ii) Europe would have found its way to reasonably stable growth.

Interconnectedness: Legal Fetters

Today we still have the problem of interconnectedness, but instead of being tied by a gold standard, in our flexible exchange rate world the ties are created by a complex web of derivative contracts – designed to protect against movements in exchange rates (amongst other things) just as the gold standard was.

Now we face a similar problem to that of abandoning the gold standard: The bankruptcy of a major derivatives dealer will result in an international solvency crisis – thus it must be prevented at all costs – just as going off gold had to be prevented. The question we face is the question that Europe faced in the mid-20s. Do we protect the solvency of the international financial system via bailouts and economic hardship – or do we let the crisis that is upon us break?

We know now that for the 20s, the crisis was going to break in the end, and can speculate that it might have been smaller if it had broken earlier. Unfortunately we cannot know whether today’s bailouts will succeed, or just like the 1929 government financed takeover of the Bodencredit Anstalt (Austria’s second largest bank) by the Credit Anstalt Bank – simply lead to a larger collapse a few years down the line. By 1931 the Austrian bailout had failed. The losses overwhelmed the Credit Anstalt bank – which was too big to save.

In the 20s, bailouts delayed the crisis, they didn’t prevent it. Today we are faced with the question: Can a bailout of the major derivatives dealers succeed? Or will we find – as the best minds of the 1920s found – that the insolvency crisis will break, if not today, than a few years from today.

The worst mistake would be to treat the current financial structure as legal fetters and listen too closely to claims that any change in legal regime will trigger a crisis of confidence. People who make these claims sound just like defenders of the gold standard in the 1920s. History proved them wrong. The current consensus of historians is that “Breaking with the dead hand of the gold standard was the key to economic revival.” (Ahamed’s Lords of Finance p. 477)

While the collapse of derivatives markets would – for obvious reasons – create its own insolvency problems, the experience with the gold standard was that it is better to recognize early that the market is breaking down – and to be prepared to rewrite contracts so that they can be honored and so that systems of international trade become operational again (without government support). Trying to prop up an old system without making the changes necessary to put it on firm foundations is a fool’s game.

Having finished Lords of Finance over the holidays, I conclude that it is an excellent introduction to the role of reparations and war debts in the problems of the 1920s and 30s. While I have always been told that reparations played a crucial role in the unravelling of Europe’s economies and polities, because these are problems of macroeconomic payment flows, the level of abstraction at which they are usually discussed has always left me in a state of incomprehension muddled with disbelief.

That Ahamed manages to present the problems of reparations in a down to earth manner that simply makes sense is an achievement in itself.

In short, despite its faults I would recommend Lords of Finance to students of the Depression because it presents the big picture of the interrelated macroeconomies with the full gamut of complex payments issues in a very accessible manner and thus can be used as a framework in which to place the pieces of a more careful study of the period.

In one sentence: First read Lords of Finance; then you’ll be ready to absorb the overwhelming detail of Eichengreen’s Golden Fetters.

For a follow up piece discussing this question: Did synthetic assets slow the current account adjustment process by vastly expanding the supply of investment grade assets and thus maintaining interest rates at a level well above the market rate?

In June Martin Wolf wrote approvingly of a report on the role of global imbalances in the financial crisis:

The authors conclude that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. With better regulation, the mess would have been smaller, as the International Monetary Fund rightly argues in its recent World Economic Outlook. But someone had to borrow this money. If it had not been households, who would have done so – governments, so running larger fiscal deficits, or corporations already flush with profits? This is as much a macroeconomic story as one of folly, greed and mis-regulation.

Since then this view has become common. For example Wolfgang Munchau in Monday’s Financial Times states: “Without excessive imbalances, the demand for products we now refer to as toxic assets would have been smaller.”

It is not clear, however, that this causal story really makes sense when analyzed in a demand and supply framework. Afterall, the “crazy lending” that Martin Wolf references represents an increase in the supply of financial assets over and above what would exist in a world with normal lending. It is far from clear why it is correct for anyone to claim that a shift in the demand for financial assets “causes” a shift in the supply of financial assets. Standard economic analysis would usually claim that a shift in the demand for financial assets results in a movement along an existing supply curve raising the price of the assets and lowering their yield.

While it is true that we observe in the data a decline in the yields of fixed income assets, this phenomenon is consistent with the observed increase in supply of these assets – as long as the shift in demand was sufficient to outweigh the effect of an increase in supply. In other words, while “crazy lending” caused an increase in supply and tended to raise the yields on these assets, this effect was overwhelmed by the increase in demand.

Now in a world with alternate assets, like ownership interests, increasing the supply of fixed income assets and therefore their yields will tend to attract investors to bonds and discourage them from entering more pricey stock markets. Thus, as long as we acknowledge that there was “crazy lending” going on and thus that the supply of fixed income assets was greater than it would have been a world without “crazy lending,” surely we must also acknowledge that this raised fixed income yields above their natural level and reduced the tendency of investors to put their money into equity and alternative assets instead of fixed income assets.

In fact, it is entirely possible that extremely low yields in fixed income markets and a shift by emerging market money into equities would have prompted reconsideration on the part of both developing and developed economies of the wisdom of maintaining massive current account imbalances. That is, it is entirely possible that “crazy lending” actually slowed the current account adjustment process – precisely because “crazy lending” prevented the returns on fixed income assets from falling to derisory levels.

In short, elementary economic analysis allows us to reach a conclusion opposite to Wolfgang Munchau’s: Without toxic assets, the quantity demanded of fixed income assets would have been smaller. We can also conclude that in the absence of toxic assets, foreign capital flows into US equity investments would have been greater. Left with a choice between derisory fixed income returns and riskier investments, foreign investors would have had a strong incentive to reduce their allocation of funds to the US market. In other words, in the absence of toxic assets the “savings glut” might have started to unwind on its own.

Thus, while emerging market demand for fixed income assets made it possible for financiers to produce and sell toxic assets, the fact remains that the supply of toxic assets increased the supply of bonds, raised the yields on bonds relative to an environment without toxic assets and by doing so interfered with the price mechanism that would tend to reduce emerging market demand for fixed income assets. Whether allowing market forces to operate would have been enough to start the unwind of global imbalances is unknowable, but we can be sure of one thing: the production and sale of toxic assets worked to keep the demand for fixed income assets high and by doing so worked against the resolution of global imbalances.